Volatility, Intermediaries, and Exchange Rates

56 Pages Posted: 20 Nov 2016 Last revised: 11 May 2020

See all articles by Xiang Fang

Xiang Fang

The University of Hong Kong

Yang Liu

The University of Hong Kong - Faculty of Business and Economics

Date Written: May 10, 2020

Abstract

We propose and estimate a quantitative model of exchange rates in which the participants
in the FX market are intermediaries subject to value-at-risk (VaR) constraints. Higher volatility
translates into tighter VaR constraints, and intermediaries require higher returns to hold
foreign assets. Therefore, foreign currency is expected to appreciate. The model quantitatively
resolves the Backus-Smith puzzle, the forward premium puzzle, the exchange rate volatility
puzzle, and explains deviations from the covered interest rate parity. Moreover, the model
implies a contemporaneous correlation and a predictive relation between proxies of leverage
constraint tightness and exchange rates. These implications are supported in the data.

Keywords: Volatility, Financial Intermediaries, Exchange Rates, Currency Return, Value-at- Risk

JEL Classification: G15, G20, F31

Suggested Citation

Fang, Xiang and Liu, Yang, Volatility, Intermediaries, and Exchange Rates (May 10, 2020). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2872904 or http://dx.doi.org/10.2139/ssrn.2872904

Xiang Fang

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

Yang Liu (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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